What is Passive Investing?

last updated 2017-06-14

What is passive investing? The simple way to buy and hold stocks, and why it can work well for your portfolio.

If the stock market seems daunting to you, it may be because there are so
many choices. Which of the tens of thousands of available stocks is right for
you? Which businesses will make money and which are teetering on the edge of
bankruptcy?

It's tempting for people to go to a professional money manager for
advice—even to make their trades for them—but the fees you pay for this service aren't often worth it.
Sure, he or she will pick investments for you and make trades for you, based on
an understanding of your goals and risk prospect, but are you getting what you
pay for? Are you getting the investments that are right for you, or
the investments that someone wants to sell you?

Fortunately, there's a better way to invest that doesn't take much effort on
your part, earns respectable returns, and doesn't waste your money paying for
advice you don't need.

Passive Investing Defined

Passive investing is a strategy of buying low-cost, high-value stocks and
funds and holding them over a long period of time. It's characterized by a few
important features:

The purchased securities tend to grow over time due to the strength of the businesses they represent

The period of holding tends to be years or decades

There are few transactions over this time—no blips of buying or selling

If you were to start today at age 25, you could put $10,000 in a low-cost S&P 500 index
fund and wait 40 years until you retire with a nice nest egg. That's as
simple as this can be. Yet there is nuance to this technique.

Advantages of Passive Investing

The main advantage of this approach is its simplicity. It's easy to explain;
pick a couple of good securities to buy, make the trade, and wait. You're in
the investment for the long term; there's no need to look in the newspaper
every day to see the closing value (just kidding; no need to check your
favorite finance site on your phone every few minutes).

It's also easy to continue to invest, with a strategy such as dollar cost averaging. Add your $100,
$500, or $1000 every month and you'll get the benefit of more invested over
time. If you've already found a great place to put your money, why not keep
investing there? This is very compatible with dividend reinvesting. Some funds even
reinvest those dividends for you.

As you're not making lots of trades besides just your regular purchases, you
won't face as many taxes as if you bought and sold often. (Depending on
how you invest, you may have to pay annual capital gains taxes on
dividends.)

Finally, passive investing is very compatible with a 401(k) account through
your employer. Most plans allow you to select from a couple of good funds, such
as the aforementioned S&P 500 index fund or a small cap fund. While these
funds aren't necessarily as good as the Vanguard gold standard, their
fees and costs should be as low as anything else in the fund list.

Disadvantages of Passive Investing

This approach does have some drawbacks. Your rate of return from passive
investing will tend to fluctuate between 6% and 10% with the S&P 500 index
fund over time. That's not a bad return at all, but it's also not the best
return you can find in the market. Yet given how much effort it takes to invest
passively, it's a good, solid return over time.

As alluded to earlier, the available options in an employer-sponsored plan
aren't necessarily the best options available from a discount stock broker with your
own plan. Then again, maxing out your 401(k), especially with employer-matching
funds, is already a good deal for many people. (Besides, if you leave your
employer, you can roll your 401(k) into a self-directed account and have access
to the entire market.)

One subtle but important drawback of this passive approach is that you're
often tying your financial fortune to the strength of the US economy. While the
S&P 500 index gave great returns in 2012, 2013, and 2014, it looks to
finish off 2015 having lost money over the year. That can be disheartening to
see on paper, but if you're putting in money every month, you're buying the US
economy at a discount—and you're investing in the long term, so you can
ride out a few rough years here and there. That may be worth it for your
perspective, even as an active investor
might hold a few stocks that have done really well in 2015.

Should Value Investors use Passive Investing?

Is a passive investing strategy compatible with value investing? It can be! The
diversification of investing in a broad market index fund lets big winners even
out big losers somewhat, and it puts your dollars in the stocks of the biggest
and best US businesses. Unless you're already extremely wealthy, you're not
going to own significant stock in Apple, GE, Exxon, Facebook, Google, Coca-Cola, et cetera anywhere else.

The expected long-term returns of passive investing are decent, certainly
worth the minimal effort it takes to get them, but if you're capable of and
interested in managing some of your own investments, setting a 15% return goal
is also possible.

In that case, a hybrid approach might be warranted. Find a threshold,
perhaps half of your portfolio in a broad index fund, a quarter in a different
fund, and a quarter to play with as an active investor. Maybe the ratio is
40/40/20, or whatever makes sense for you. Whatever you decide, the simplicity
of passive investing—especially in a low-cost, low-churn fund—can
be a real advantage to earn decent returns and protect your capital while you
pursue great individual stocks at good prices.